Q&A: World stock market falls
Stock markets around the world have been falling sharply on fears of a credit crunch that could affect the financial sector. What is causing the fall and how will it affect the ordinary individual?
What has been happening to the world's stock markets?
The value of the world's major companies has taken a tumble as the world's stock markets have plunged in recent days - one of several such sharp declines in the past few months.
The move has wiped billions of dollars off the value of shares owned by individuals and institutions such as pension funds and insurance companies.
This most recent fall started when a French bank, BNP, said it would freeze three investment funds because it could no longer accurately measure their value.
Markets fell around the world because they were nervous that the problems are not just confined to French banks, but are more widespread in the financial sector - especially in relation to sub-prime mortgage lending.
Why did central banks intervene?
It was not just stock markets that have been worried.
Interest rates in credit markets - such as the bonds issued by companies and governments - have been rising as investors price in previously unknown risks.
Fears that more undisclosed bad debts would surface in the banking sector led other banks to cut back on their everyday lending to one another.
This drove up the bank's overnight lending rate, which usually tracks the base rate set by central banks.
In London, as the crisis began, the cost of overnight lending (the London Interbank Offered Rate) rose dramatically, from 5.85% on Wednesday 8 August to 6.45% on Friday 10 August, and similar sharp changes occured in Frankfurt and New York.
If this had continued, it would have undercut the ability of world central banks to regulate interest rates, and would have raised the cost of borrowing across the board.
That led the European Central Bank and the US Federal Reserve to step in and pump in billions of dollars to prop up the financial system.
What are the markets worried about?
The underlying fear relates to the collapse of the so-called sub-prime mortgage market in the US.
In the past five years, extraordinarily low interest rates in the US have led banks and other financial institutions to lend substantial sums of money to people with poor or no credit histories.
The idea was that, even if they eventually couldn't pay, the banks could recoup any losses by repossessing and reselling the houses - and in any case, house price rises would cushion the blow.
In the most extreme cases, mortgage brokers were handing out what came to be known as "Ninja" loans, to people with no income and no job or assets.
Often the loans were "no-doc", where the borrower did not have to provide proof of how much they earned. Recent research suggests that in many if not most of these, borrowers (or their brokers) lied about their income.
But now as interest rates have risen, so have repossessions. The US housing market has collapsed and the banks find themselves saddled with a lot of bad debts.
However, it is not just a problem for US banks.
Globalisation has meant that much of this mortgage debt has been sliced up into small pieces, repackaged as "collaterised mortgage obligations" and sold on to financial institutions and individual investors around the world.
And now, no one, including the central banks, is certain how much of these bad debt financial institutions or individuals are holding.
What are the wider implications?
Even if the central banks stem the financial panic, there seems to have been a general shift in market perceptions about risk.
Generally, the riskier the investment, the higher the interest rate - but now the additional premium for risky investments (the "spread") is set to widen sharply.
When people with money to lend become worried about risks, they tend to put their money in safe investments.
So there has been a rush to invest in government bonds, like US Treasury bonds, and safe currencies, like the dollar.
In contrast, people are now demanding much higher interest rates to lend to smaller companies or to the governments of developing countries.
Investors have also grown wary of lending to private equity funds who want to buy and sell companies.
This may mean that this is much less takeover activity than in the past few years, which could also affect the stock market.
How long will it go on?
Stock market fluctuations are a normal part of stock market activity, and no one can say how far shares could fall or how long the slowdown could persist.
Markets have had quite a sharp rise in the past 18 months, and the current correction may simply return them to previous levels.
Broadly, company profits have been strong and the world economy seems to be entering a period of revival, especially in Europe and Japan.
However, stock markets look at future expectations, so they may be concerned that corporate profits have already peaked.
What does it mean to you?
Many individuals own stocks and shares - about half of all US households, and around a quarter of those in the UK.
If the stock market falls continue, they may feel less wealthy - and be less likely to buy goods and services, slowing the economy.
In addition, many pension funds own shares which make up part of their portfolio used to pay people's occupational pensions.
If shares fall, they may have less money to pay future pensions, and employee contributions may have to rise.
Story from BBC NEWS:
http://news.bbc.co.uk/go/pr/fr/-/2/hi/business/6939899.stm
Published: 2007/08/16 08:15:51 GMT
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